Oda bultum University Development Economics II Lecture Note

Chapter Five
International Trade, Foreign Direct Investment, Foreign Aid and Development

Objective
 After completing this chapter, you will be able to
o Understand the role of international trade in Economic Development.
o Identify the pros and cons of foreign direct investment.
o Explain the role of foreign aid in Economic Development of LDCs.
o Know the growing role of nongovernmental organizations (NGOs).

1-International Trade and Development

Introduction
 International trade is exchange of capital, goods, and services across international borders
or territories.
o It refers to exports of goods and services by a firm to a foreign-based buyer
(importer) in most countries; it represents a significant share of gross domestic
product (GDP). While international trade has been present throughout much of
history, its economic, social, and political importance has been on the rise in recent
centuries.

 Industrialization, advanced transportation, globalization, multinational corporations, and

outsourcing are all having a major impact on the international trade system.
o Increasing international trade is crucial to the continuance of globalization.
o International trade is a major source of economic revenue for any nation that is
considered a world power.
o Without international trade, nations would be limited to the goods and services
produced within their own borders.

 International trade is in principle not different from domestic trade as the motivation and
the behavior of parties involved in a trade do not change fundamentally regardless of
whether trade is across a border or not.
o The main difference is that international trade is typically more costly than domestic
trade. The reason is that a border typically imposes additional costs such as tariffs,
time costs due to border delays and costs associated with country differences such as
language, the legal system or culture.
o Another difference between domestic and international trade is that factors of
production such as capital and labor are typically more mobile within a country than
across countries. Thus international trade is mostly restricted to trade in goods and
services, and only to a lesser extent to trade in capital, labor or other factors of
production. Then trade in goods and services can serve as a substitute for trade in
factors of production. Instead of importing a factor of production, a country can
import goods that make intensive use of the factor of production and are thus
embodying the respective factor. An example is the import of labor-intensive goods
by the United States from China. Instead of importing Chinese labor the United
States is importing goods from China that were produced with Chinese labor.

International trade is also a branch of economics, which, together with international

finance, forms the larger branch of International Economics.

1
Oda bultum University Development Economics II Lecture Note
 Trade theories are indeed important, because they explain:
o The first purpose of trade theory is to explain observed trade.
 That is, we would like to be able to start with information about the characteristics of
trading countries, and from those characteristics deduce
what they actually trade, and be right. That’s why we have a
models that postulate different kinds of characteristics as the reasons for
trade.
o Secondly, it would be nice to know about the effects of trade on the domestic
economy.
o A third purpose is to evaluate different kinds of policy. Here it is good to remember
that most trade theory is based on neoclassical microeconomics, which assumes a
world of atomistic individual consumers and firms. The consumers pursue
happiness (“maximizing utility”) and the fi assumptions of perfect information, perfect competition, and so on.

Importance of Exports to Different Developing Nations

 Developing countries are generally more dependent on trade than developed countries are.
 o This is shown clearly in the case of traditionally export-oriented Japan, whose exports
amount to roughly 10% of GDP, whereas LDCs with somewhat larger populations
such as Indonesia, Bangladesh, and Nigeria export a far higher share
of output.
o Newly Industrialized Countries still command a dominant position in
developing- country exports.
 For example, in 2000, South Korea alone exported more than all of South Asia
and sub-Saharan Africa combined.
 South Korea and Taiwan together exported more manufactured goods in
2000 than the entire regions of Latin America, the Caribbean, the Middle
East, North Africa, South Asia, and sub-Saharan Africa combined.

 The export performance of the majority of LDCs has been relatively weak compared with
the export performance of rich countries.
o It relates to the concept of elasticity of demand, most statistical studies of world
demand patterns for different commodity groups reveal that in the case of
primary products, the income elasticity of demand is relatively low.
 The percentage increase in quantity of primary products
demanded by importers (mostly rich nations) will rise by less than
the percentage increase in their Gross National Incomes (GNIs).
By contrast, for fuels, certain raw materials, and manufactured
goods, income elasticity is relatively high. For example, it has been
estimated that a 1 % increase in developed country incomes will
normally raise their import of foodstuffs by a mere 0.6%,
agricultural raw materials such as rubber and vegetable oils by
0.5%, but of petroleum products and other fuels by 2.4%, and
manufactures by about 1.9%.
 Consequently, when incomes rise in rich countries, their demand
for food, food products, and raw materials from the developing
nations goes up relatively slowly, whereas their own as well as
LDC demand for manufactures, the production of which is

2
Oda bultum University Development Economics II Lecture Note
dominated by the developed countries, goes up very rapidly. The net result of this low income
elasticity of demand is the tendency for the relative price of
primary products to decline overtime.
o Moreover, since the price elasticity of demand for (and supply of) primary
commodities also tends to be quite low (i.e., inelastic), any shifts in demand or
supply curves can cause large and volatile price fluctuations. Together these two
elasticity phenomena contribute to what has come to be known as export
earnings instability, which has been shown to lead to lower and less predictable
rates of economic growth.

The Terms of Trade and the Prebisch-SingerThesis

 The relationship or ratio between the price of a typical unit of exports and the price of a
typical unit of imports is called the commodity terms of trade, and it is expressed as Px/Pm
where Px and Pm represent the export and import price indexes, respectively, calculated on
the same base period.
 The commodity terms of trade are said to deteriorate for a country if Px/Pm falls, that is, if
export prices decline relative to import prices, even though both may rise.
 Historically, the prices of primary commodities have declined relative to
manufactured goods.
 As a result, the terms of trade have on the average tended to worsen over
time for the non-oil-exporting developing countries while showing a relative
improvement for the developed countries.

 The main theory for the declining commodity terms of trade is known as the Prebisch-
Singer thesis, after two famous development economists who explored its implication in
the 1950s.
o They argued that there was and would continue to be a secular decline in the terms
of trade of primary-commodity exporters due to a combination of low income and
price elasticity of demand.
o This decline would result in a long-term transfer of income from poor to rich
countries that could be combated only by efforts to protect domestic manufacturing
industries through a process that has come to be known as import substitution.

 Both because of this theory and unfavorable terms of trade trends, developing countries
have been doing their utmost over the past several decades to diversify into manufactures
exports.
o After a slow and costly start, these efforts have resulted in a dramatic shift in the
composition of developing-country exports, especially among middle-income
LDCs. Led at East first Asian Tiger by “economies the of “South Korea, Taiwan,
Hong Kong, and Singapore and now followed by many other countries in Asia,
including China and India, the share of merchandise exports accounted for by
manufactured goods has risen strongly in many developing countries.

 Unfortunately, this structural change has not brought as many benefits to most developing
countries as they had hoped, because relative prices within manufactures have also
diverged: Over the last quarter century, the prices of the basic manufactured goods
exported by poor countries fell relative to the advanced products exported by

3
Oda bultum University Development Economics II Lecture Note
rich countries. The price of textiles fell especially precipitously, and low-skilled electronic goods
are not far behind.

Benefits of International Trade

 In a world of free trade, international prices and costs of production determine how much a
country should trade in order to maximize its national welfare. Countries should follow the
principle of comparative advantage and not try to interfere with the free workings of the
market.
1. Trade is an important stimulator of economic growth. It enlarges a country's
consumption capacities, increases world output, and provides access to scarce
resources and worldwide markets for products without which poor countries would
be unable to grow.
2. Trade tends to promote greater international and domestic equality by equalizing
factor prices, raising real incomes of trading countries, and making efficient use of
each nation's and the world's resource endowments (e.g., raising relative wages in
labor-abundant countries and lowering them in labor-scarce countries).
3. Trade helps countries achieve development by promoting and rewarding the
sectors of the economy where individual countries possess a comparative ad-
vantage, whether in terms of labor efficiency or factor endowments. It also lets them
take advantage of economies of scale.
 Finally, to promote growth and development, an outward-looking international policy is
required. In all cases, self-reliance based on partial or complete isolation is asserted to be
economically inferior to participation in a world of unlimited free trade.

2-Foreign Direct Investment

Introduction
 International flow of financial resources takes two main forms:
o Private foreign direct and portfolio investment, consisting of
 Foreign "direct" investment by large multinational (or transnational) corporations
usually with headquarters in the developed nations.
 Foreign "portfolio investment (e.g., stocks, bonds and notes) in LDC
"emerging" credit and equity markets by private institutions (banks, mutual
funds, corporations) and individuals.
 Public and private development assistance (foreign aid), from
 Individual national governments and multinational donor agencies.
 Private nongovernmental organizations (NGOs), most working directly with
developing nations at the local level.

Private Foreign Direct Investment: Pros and Cons for Development

 The basic arguments for and against the developmental impact of private foreign
investment in the context of the type of development it tends to foster can be summarized as
follows.
1. Foreign private investment (as well as foreign aid) is typically seen as a way of filling in
gaps between the domestically available supplies of savings, foreign exchange,
government revenue, and human capital skills and the desired level of these
resources necessary to achieve growth and development targets. That is, the first and
most often cited contribution of private foreign investment to national development is

4
its role in filling the resource gap between targeted or desired investment and locally mobilized
savings.
2. The second contribution is filling the gap between targeted foreign-exchange
requirements and those derived from net export earnings plus net public foreign aid.
This is the so-called foreign-exchange or trade gap. An inflow of private foreign capital
can not only alleviate part or all of the deficit on the balance of payments current
account but can also function to remove that deficit over time if the foreign-owned
enterprise can generate a net positive flow of export earnings.
3. The third gap said to be filled by foreign investment is the gap between targeted
governmental tax revenues and locally raised taxes. By taxing MNC profits and
participating financially in their local operations, LDC governments are thought to be
better able to mobilize public financial resources for development projects.
4. Fourth, there is a gap in management, entrepreneurship, technology, and skill
presumed to be partly or wholly filled by the local operations of private foreign firms.
Not only do multinationals provide financial resources and new factories to poor
countries, but they also supply a "package" of needed resources, including management
experience, entrepreneurial abilities, and technological skills that can then be transferred
to their local counterparts by means of training program and the process of learning by
doing.

 There are three basic arguments against private foreign investment in general and the
activities of MNCs in particular.
1. Although MNCs provide capital, they may lower domestic savings and investment
rates by stifling competition through exclusive production agreements with host
governments, failing to reinvest much of their profits, generating domestic incomes
for groups with lower savings propensities, and inhibiting the expansion of
indigenous firms that might supply them with intermediate products by instead
importing these goods from overseas affiliates. MNCs also raise a large fraction of
their capital locally in the developing country itself; and this may lead to some
crowding out of investment of local firms.
2. Although the initial impact of MNC investment is to improve the foreign exchange
position of the recipient nation, its long-run impact may be to reduce foreign-
exchange earnings on both current and capital accounts. The current account may
deteriorate as a result of substantial importation of intermediate products and capital
goods, and the capital account may worsen because of the overseas repatriation of
profits, interest, royalties, management fees, and other funds.
3. Although MNCs do contribute to public revenue in the form of corporate taxes, their
contribution is considerably less than it should be as a result of liberal tax
concessions, the practice of transfer pricing, excessive investment allowances,
disguised public subsidies, and tariff protection provided by the host government.
4. The management, entrepreneurial skills, ideas, technology, and overseas contacts
provided by MNCs may have little impact on developing local sources of these
scarce skills and resources and may in fact inhibit their development by stifling the
growth of indigenous entrepreneurship as a result of the MNCs' dominance of local
markets.

 The arguments both for and against private foreign investment are still far from being
completed.

5
Oda bultum University Development Economics II Lecture Note

 The quantitative and qualitative impact of MNC investments in developing

countries remains to be assessed. As a result of the widespread adoption of
market reforms, open economies, and privatization of state-owned
enterprises, MNCs have been intensifying their global factory strategy,
particularly in Asia and Latin America.

Multinational Corporation (MNC)

 An MNC is most simply defined as a corporation or enterprise that conducts and
controls productive activities in more than one country.
o These huge firms, mostly from North America, Europe, and Japan (but also
increasingly from newly industrializing countries like South Korea, Taiwan, and
Brazil) present a unique opportunity, but may pose serious problems for the
many developing countries in which they operate.
 Multinational corporations are not in the development business; their objective is to
maximize their return on capital.
o This is why over 90% of global FDI goes to other industrial countries and the
fastest growing LDCs.
o MNCs seek out the best profit opportunities and are largely unconcerned with
issues such as poverty, inequality, and unemployment alleviation.
o MNCs employ a relatively small though rapidly growing number of people in
LDCs.
o The jobs tend to be concentrated in the high-wage, modern urban sector. Despite
their insignificance in terms of the overall national employment picture, these
corporations often exert a disproportionate influence on urban salary scales and
migrant worker perceptions.

3-Foreign Aid
 In addition to export earnings and private foreign direct and portfolio investment, the final
two major sources of LDC foreign exchange are public (official) bilateral and multilateral
development assistance and private (unofficial) assistance provided by nongovernmental
organizations. Both of these activities are forms of foreign aid, although only public aid is
usually measured in official statistics.

 In principle, all governmental resource transfers from one country to another should be
included in the definition of foreign aid.

 Even this simple definition, however, raises a number of problems. For one
thing, many resource transfers can take disguised forms, such as the granting
of preferential tariffs by developed countries to LDC exports of manufactured
goods. This permits LDCs to sell their industrial products in developed-
country markets at higher prices than would otherwise be possible. There is
consequently a net gain for LDCs and a net loss for developed countries,
which amounts to a real resource transfer to the LDCs. Such implicit capital
transfers, or disguised flows, should be counted in qualifying foreign aid
flows. Normally, however, they are not.

6
Oda bultum University Development Economics II Lecture Note

 However, we should not include all transfers of capital to LDCs, particularly the capital
flows of private foreign investors.
 Private flows represent normal commercial transactions, are prompted by
commercial considerations of profits and rates of return, and therefore should
not be viewed as aid to the LDCs.
 Commercial flows of private capital are not a form of foreign assistance, even though
they may benefit the developing country in which they take place.
 Economists have defined foreign aid, therefore, as any flow of capital to LDCs that meets
two criteria:

 (1) Its objective should be noncommercial from the point of view of the donor, and

 (2) It should be characterized by concessional terms; that is, the interest rate
and repayment period for borrowed capital should be softer (less stringent)
than commercial terms.

 Even this definition can be inappropriate, for it could include military aid, which is both
noncommercial and concessional.
 Normally, however, military aid is excluded from international economic
measurements of foreign aid flows.

 The concept of foreign aid that is now widely used and accepted, therefore, is
one that encompasses all official grants and concessional loans, in currency or
In kind, that are broadly aimed at transferring resources from developed to
less developed nations on development or income distribution grounds.
Unfortunately, there often is a thin line separating purely developmental
grants and loans from sources ultimately motivated by security or commercial
interests.

 The concept of foreign aid that is now widely used and accepted is one that encompasses all
official grants and concessional loans, in currency or in kind that are broadly aimed at
transforming resources from developed to less developed nations.
 Just as there are conceptual problems associated with the definition of foreign
aid, so too there are measurement and conceptual problems in the calculation
of actual development assistance flows.

 In particular, three major problems arise in measuring aid.

 First, we cannot simply add together the dollar values of grants and loans;
each has a different significance to both donor and recipient countries. Loans
must be repaid and therefore cost the donor and benefit the recipient less than
the nominal value of the loan itself. Conceptually, we should deflate or
discount the dollar value of interest-bearing loans before adding them to the
value of outright grants.

 Second, aid can be tied either by source (loans or grants have to be spent on
the purchase of donor-country goods and services) or by project (funds can
only be used for a specific project, such as a road or a steel mill). In either case,
the real value of the aid is reduced because the specified sources likely to be an
expensive supplier or the project is not of the highest priority (otherwise, there
would be no need to tie the aid). Furthermore, aid may be tied to the

7
importation of capital-intensive equipment, which may impose an additional real resource cost,
in the form of higher unemployment, on the recipient nation. Or the project
itself may require purchase of new machinery and equipment from
monopolistic suppliers while existing productive equipment in the same
industry is being operated at very low levels of capacity.

 Finally, we always need to distinguish between the nominal and real value of
foreign assistance, especially during periods of rapid inflation. Aid flows are
usually calculated at nominal levels and tend to show a steady rise over time.
However, when deflated for rising prices, the actual real volume of aid from
most donor countries has declined substantially during the past decade. For
example, during the period 1960- 1990, the nominal outflow of foreign aid
from the United States increased by 130%, but the real value actually declined
by nearly30%.

Why Donors Give Aid

 Donor-country governments give aid primarily because it is in their political, strategic, or
economic self-interest to do so.
1. Political Motivations: Political motivations have been by far the more important for
aid-granting nations, especially for the major donor countries. The United States has
viewed foreign aid from its beginnings in the late 1940s under the Marshall Plan,
which aimed at reconstructing the war-torn economies of Western Europe, as a
means of containing the international spread of communism. When the balance of
cold-war interests shifted from Europe to the developing world in the mid-1950s, the
policy of containment embodied in the U.S. aid program dictated a shift in emphasis
toward political, economic, and military support for "friendly" less developed
nations, especially those considered geographically strategic. Most aid programs to
developing countries were therefore oriented more toward purchasing their security
and propping up their sometimes shaky regimes than promoting long-term social
and economic development.
2. Economic Motivations and Self-Interest: The increasing tendency toward providing
loans instead of outright grants and toward tying aid to the exports of donor
countries has saddled many LDCs with substantial debt repayment burdens. It has
also increased their import costs because aid tied to donor- country exports limits the
receiving nation’s freedom-cost and to suitable shop capital and around f intermediate goods. Tied
aid in this sense is clearly a second-best option to untied
aid. A large fraction of U.S. aid has been spent on American consultants and other U.S.
businesses.

Why LDC Recipients Accept Aid

 The reasons why developing nations, at least until recently, have been eager to accept aid,
even in its most stringent and restrictive forms have been given much less attention than the
reasons why donors provide aid.
 The major reason is economic. It is assumed that aid is a crucial and essential ingredient in the
development process.
 It supplements scarce domestic resources,
 It helps transform the economy structurally and
 It contributes to the achievement of LDC takeoffs into self-sustaining EG.

8
Oda bultum University Development Economics II Lecture Note

 The two minor though important motivations for LDCs to seek aid are political and moral.

In some countries, aid is seen by both donor and recipient as providing greater
political leverage to the existing leadership to suppress opposition and
maintain itself in power. In such instances, assistance takes the form not only
of financial resource transfers but of military and internal security
reinforcement as well.

Effects of Aid
 The issue of the economic effects of aid, like that of the effects of private foreign investment,
is fraught with disagreement.
o On one side are the economic traditionalists, who argue that aid has indeed
promoted growth and structural transformation in many LDCs.
 Many proponents of foreign aid in both developed and developing
countries believe that rich nations have an obligation to support the
economic and social development of the Third World.
o On the other side are critics who argue that aid does not promote faster growth
based the following grounds:
 Aid does not promote faster growth but may in fact retard it by
substituting for, rather than supplementing, domestic savings and
investment and by exacerbating LDC balance of payments deficits as
a result of rising debt repayment obligations.
 Aid is further criticized for focusing on and stimulating the growth of
the modern sector, thereby increasing the gap in living standards
between the rich and the poor in Third World countries.
 Some critics assert that foreign aid has been a positive force for anti-
development in the sense that it both retards growth through reduced
savings and worsens income inequalities.
 Rather than relieving economic bottlenecks and filling gaps aid and
for that matter private foreign investment- not only widens existing
savings and foreign exchange resource gaps but may even create new
ones (e.g. Urban-rural, modern-traditional sectors, gaps).
 Foreign aid has been a failure because it has been largely
appropriated by corrupt bureaucrats, has stifled initiative, has
generally and engendered a welfare mentality on the part of recipient
nations.

 Quit apart from this criticism, the 1970s and 1980s witnessed, on the donor side, a growing
disenchantment with foreign aid as domestic issues like inflation, unemployment,
government deficits, and balance of payments problems gained increasing priority over
international politics.
 The expression aid weariness was often used to describe the attitude of
developed countries toward foreign assistance.
 Taxpayer become more concerned with domestic economic problems,
especially as they increasingly realized that their tax dollars allocated to
foreign aid were often benefiting the small elite groups in LDCs who in many
cases were richer than themselves.

9
Oda bultum University Development Economics II Lecture Note

 In order to minimize the challenges in relation to Foreign Aid, the World Bank introduced
the Aid effectiveness principles. These were:
Ownership by the government and participation of affected people –linked to
the government’s own commitment to poverty
Strong administrative and institutional capacity –an environment of governance.

Sound policies and good public sector management –meaning governments

facilitating open markets and investing in infrastructure and people.
Close coordination by donors –to simplify aid management for recipient
governments.
Improvements in donors‟–to focus own less business on puts and park more on the effects of
development at the country level.

4- Nongovernmental Organizations (NGOs)

 While there is much debate about the pros and cons of multinational corporate investment
and public foreign aid in developing countries, few people doubt· the value of one of the
fastest -growing and most significant forces in the field of development assistance, private
nongovernmental organizations (NGOs).
o NGOs are voluntary organizations that work with and on behalf of mostly local
grassroots people's organizations in developing countries.
o They also represent specific local and international interest groups with concerns
as diverse as providing emergency relief, protecting child health, promoting
women's rights, alleviating poverty, protecting the environment, increasing food
production, and providing rural credit to small farmers and local businesses.
o NGOs build roads, houses, hospitals, and schools. They work in family-planning
clinics and refugee camps. They teach in schools and universities and conduct
research on increasing farm yields.
 NGOs include religious groups, private foundations and charities, research organizations,
and federations of dedicated doctors, nurses, engineers, agricultural scientists, and
economists.
o Many work directly on grassroots rural development projects; others focus on relief
efforts for starving or displaced peoples.
 The great value of NGOs is twofold.
o First, being less constrained by political imperatives and motivated largely by
humanitarian ideals, most NGOs are able to work much more effectively at local
levels with the very people that they are trying to assist than massive bilateral and
multilateral aid programs could.
o Second, by working directly with local people's organizations, many NGOs are able
to avoid the suspicion and distrust on the part of the mostly poor people that they
serve that their help is less than sincere or likely to be short-lived.
 It is estimated that NGOs in developing countries are affecting the lives of millions people.

The End
Abdella M.
“” Wish You All the Best””

10