| EMBARGO The contents of this Report must not be quoted or summarized in the print, broadcast or electronic media before 16 September 2004 17:00 GMT |
Concerns have been growing in recent years about the disappointing developmental effects of closer integration into the world economy. Strategies based on the "openness model" have not enabled developing countries to establish a virtuous interaction between international finance, domestic capital formation and export growth. Trade and Development Report 2004 (1), released today by UNCTAD, argues that the "openness model" is too narrow a basis for development through integration. According to the Report, a more comprehensive policy framework is required that addresses the need to reinforce coherence between the international trading system and the international monetary and financial system.
While the Doha round of multilateral trade negotiations, like its predecessors, aims at further liberalization of international trade by reducing trade barriers and restricting trade-distorting domestic policies, these negotiations pay scant attention to trade imbalances and distortions originating in the monetary and financial system. The Report documents the lack of policy coherence in today´s global economy and proposes ways to approach the issue of coherence so as to maximize the developmental effects of integration into the world economy.
In addition to a favourable international trading environment, developing countries need internationally competitive firms to reap the full benefits of their integration into the world economy. While a host of microeconomic factors influence competitiveness, the TDR 2004 stresses that macroeconomic policies also matter, especially those related to interest rates -- an important factor determining domestic capital formation -- and exchange rates, which have a crucial bearing on trade performance. However, in countries with a liberalized capital account, the ability of countries to manage interest and exchange rates is circumscribed by the influence of private international capital flows.
Lack of coherence compromises integration into world economy
The new UNCTAD report maintains that the international economic system of the post-second world war, with its limited private international capital flows and convertible currencies at fixed, but adjustable, exchange rates, provided a stable environment for international trade, in which participants in international trade negotiations could predict the full extent to which the competitive position of domestic industries would be affected by tariff cuts. But with the widespread adoption of floating, and rapidly increasing private international capital flows, efforts to achieve coherence between the international trade, monetary and financial systems have gained new importance. The liberalization of capital movements has not, as hoped, removed the balance-of-payments constraint on developing countries; rather, it has contributed to a de-linking of financial flows from international trade.
As a result, the international competitiveness of firms in developing countries that have liberalized their capital account at an early stage in the integration process has often been adversely affected by exchange rate movements in response to changes in the level and direction of private capital flows. An increasing number of developing countries have tried to maintain or improve the competitiveness of their firms by avoiding real currency overvaluation through unilateral managed floating of their exchange rates. But such measures cannot replace international coordinated action, UNCTAD says. First, because only a few developing countries will be able to defend a certain exchange rate over a longer period of time, and second, because internationally uncoordinated exchange rate management entails a risk of competitive devaluations.
UNCTAD is thus calling for new efforts to increase the coherence among the international trade, monetary and financial systems to reduce potentially destabilizing interactions between trade and international finance. In order to foster a virtuous circle of interactions between international finance, export activities and domestic capital formation, coherence also needs to be strengthened between global processes and arrangements, on the one hand, and national development strategies, on the other.
Monetary management has become more difficult
The liberalization of capital flows in the past 30 years, and the sizeable increase in the scale and variety of cross-border financial transactions, have subjected the currencies of financially open developing countries to increased volatility and considerable gyrations. This has frequently contributed to serious problems with managing interest and exchange rates in a manner conducive to domestic capital formation and to the international competitiveness of firms producing tradeable goods. These problems have also produced more frequent financial crises, even in countries with good track records of macroeconomic discipline. Since the early 1990s, phases of rapidly rising private capital flows to developing countries have often been associated with prolonged periods of exchange rate appreciation, followed by abrupt and sharp devaluations in the context of such crises. Domestic capital formation, an essential requirement for successful participation in international trade, suffered in both instances.
Small depreciations of the real exchange rate generally improve a country´s external trade performance. Sharp and abrupt depreciations during a crisis, by contrast, can seriously compromise the ability of domestic exporters to benefit proportionally from their increased international cost competitiveness. In such cases, even those firms whose cost competitiveness significantly improves as a result of the depreciation are often unable to expand production capacity through new investment, or even to maintain production at pre-depreciation levels in the short term. Sharp currency depreciations are typically associated with a drop in domestic economic activity, a need to cut imports of intermediate and capital goods and a reduced availability of finance from both domestic and external sources.
Inconsistent policy advice
Sharp and durable real depreciations in one economy have a strong negative impact on the external trade position of others, the Report shows. Evidence from the Asian crisis points to the risk of competitive devaluations in response to adverse exchange rate shocks. Countries whose exporters compete directly with those in the crisis-affected country face pressure to depreciate their currencies in order to avoid a loss in international competitiveness. In such cases, exporters in the crisis-affected country do not realize the rise in demand for their products they would have hoped for.
In effect, the volatility in international financial markets and particularly in private capital flows that leads to such exchange rate movements can reduce international competitiveness and also reduce the profit incentive for firms in the countries concerned to undertake productivity-enhancing and capacity-enlarging investment. There is thus some inconsistency in the policy advice that encourages developing countries to adopt rapid financial liberalization while at the same time prompting them increasingly to rely on productivity-enhancing investment to strengthen their competitiveness for improved trade performance.
International action required
Under some circumstances, and particularly when a period of real currency appreciation has hampered export performance, real currency depreciations can improve international competitiveness and boost exports. However, in a well-designed global economic system, the advantages of a currency devaluation for one country have to be balanced against the disadvantages for others. The current multilateral trade system ignores the problems arising from trade imbalances and distortions that originate in the international monetary and financial system. Moreover, the existing system of global economic governance does not offer any mechanism to deal with these problems. UNCTAD stresses that measures at the national level cannot substitute for appropriate international arrangements. Nevertheless, an increasing number of developing countries have chosen policies to avoid a currency appreciation that could compromise trade performance. East Asian countries pioneered this approach. They did not apply the "open capital market strategy" at an early stage of their catching-up process and tried to avoid dependence on foreign capital flows. Based on current account surpluses and a competitive exchange rate, they simultaneously managed the real exchange rate, a key determinant of exporters´ international cost competitiveness, and the real interest rate, a key determinant of domestic investment.
Managed floating, however, faces an adding-up problem at the global level. Not all countries can simultaneously manage the movements of their exchange rate and achieve their targeted rates. The exchange rate is a multilateral phenomenon, and UNCTAD is warning that attempts by many countries to keep their currencies undervalued could end up in a race to the bottom - or in competitive devaluations - that would be as disastrous for the world economy as the experience of the 1930s. Moreover, given the size and inherent volatility of international short-term capital flows, only those developing countries that are big and competitive enough to withstand strong and sustained attempts by the international financial markets to move the exchange rate in a particular direction will be able to manage the floating successfully.
The TDR 2004 suggests that since exchange rate policies have the same international dimension as trade policies, multilateral or global arrangements similar to those of the multilateral trade system would be required to solve this problem. Indeed, the main idea behind the establishment of the Bretton Woods system and the IMF in the 1940s was to avoid competitive devaluations.
As changes in the exchange rate that imply deviation from purchasing-power parity affect international trade in a way comparable to tariffs and export duties, such changes should also be governed by multilateral regulations, UNCTAD suggests. One possible solution today would be to review the balance-of-payments provisions of the GATT. Another would be to establish a rules-based and truly multilateral monetary system, one in which all countries, and not just a few, are involved in major decisions. Such a multilateral regime would, among other things, require countries to specify their reasons for sizeable real depreciations and the dimensions of any changes needed. If such rules were strictly applied, substantial changes in the real exchange rate of individual countries could be avoided.
But if there is no multilateral solution to the currency problem, the only way out for many countries is to resort to controls of short-term capital flows and/or to follow a strategy of unilateral exchange rate fixing, avoiding sizeable and lasting overvaluation. If developing countries are allowed to prevent destabilizing capital inflows and outflows, such unilateral choices and misallocations can be avoided; but resort to controls or permanent intervention should not replace the search for an appropriate exchange rate system at the regional and global levels, UNCTAD says.
