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Trade, Foreign Capital and Development

Foreign trade and foreign private capital were earlier thought to have no role to play in development. Today they are thought to have rather important roles. On the other hand, foreign aid was earlier thought to have an important role while "aid pessimism" dominates development thinking today. This paper examines afresh the extent to which foreign trade, foreign private capital and foreign aid are helpful or unhelpful for development in labour-surplus dual economies. It concludes that managed trade is generally helpful while foreign private capital and foreign aid can be helpful only under certain rather special conditions.


Trade, Foreign Capital and Development

Ajit K Ghose

Foreign trade and foreign private capital were earlier thought to have no role to play in development. Today they are thought to have rather important roles. On the other hand, foreign aid was earlier thought to have an important role while “aid pessimism” dominates development thinking today. This paper examines afresh the extent to which foreign trade, foreign private capital and foreign aid are helpful or unhelpful for development in labour-surplus dual economies. It concludes that managed trade is generally helpful while foreign private capital and foreign aid can be helpful only under certain rather special conditions.

Ajit K Ghose (ghose.ajit@gmail.com) is visiting professor, Institute for Human Development, New Delhi.

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n the 1950s and the 1960s, development economists saw no role for either foreign trade or foreign private capital in late industrialisation, which was viewed as the principal route to development. Indeed, it was widely held that free trade and unrestricted inflow of foreign private capital would undermine late industrialisation so that protection against both was necessary. Foreign aid, however, was thought to have an important role to play in development. Today, in sharp contrast, openness to trade and foreign private capital is thought to be not just conducive to but essential for development. On the other hand, there is deep scepticism about the effectiveness of foreign aid in promoting development.

Underlying these changes in ideas is a shift of paradigm in development economics. In the 1950s and the 1960s, the problem of development was viewed as a problem of growth in the modern sector of labour-surplus dual economies. In the 1970s, this framework gradually yielded place to what Hirschmann (1981) calls “monoeconomics” – the idea that neoclassical economics is of universal applicability. In the “monoeconomics” perspective, developing economies are viewed merely as poor economies rather than as labour-surplus dual economies. It is thought, moreover, that these economies failed to grow (and hence remained poor) not because they lacked resources (labour, capital and entrepreneurship) but because they suffered severe coordination failure. On this view, foreign trade and foreign private capital could be seen as cures for coordination failure.

I have argued elsewhere (Ghose 2010) that characterisation of developing economies as labour-surplus dual economies is far more appropriate than their characterisation as merely the poor cousins of developed economies. I have also examined there the requirements, challenges and feasible strategies of development in labour-surplus dual economies. The objective of this paper is to extend that analysis to an assessment of the roles of foreign trade and foreign capital (private as well as public) in the process of development in such economies.

Before embarking on this assessment, it is necessary to briefly state a few of the relevant characteristics of a labour-surplus dual economy.1 Such an economy is composed of two sectors – a relatively small modern sector and a relatively large traditional sector. In the traditional sector, where production is for self-consumption, there is substantial surplus labour. This means that workers in the sector are engaged in work and income sharing, which is made possible by the institutional arrangements – the systems of self-employment and casual wage employment – that prevail in the sector. In the modern sector, there are capitalistic entrepreneurs (including the state) who employ capital in production and employ labour on a regular wage-paid basis. They


produce for profit, save out of the profit earned in the current period and invest this to expand production and to thereby earn more profit in the next period. The wage per worker in the modern sector, set by government regulations and institutional arrangements such as collective bargaining, is much higher than the labour-income per worker in the traditional sector. This means an “unlimited” supply of workers to the modern sector on the one hand and absence of unemployment in the modern sector on the other. Development in such an economy can only occur through simultaneous processes of labour transfer from the traditional to the modern sector and of growth of output per worker in the traditional sector. So development requires, simultaneously, expansion and growth of the entrepreneurial class (and thus of output and employment) in the modern sector and investment by the State in the traditional sector (which does not possess an entrepreneurial class). These requirements must be kept in view in assessing the role of foreign trade and foreign capital in economic development in labour-surplus dual economies.

Trade and Development

To consider the role of trade in development, we must begin by recognising that only the modern sector of a developing country can and does engage in trade with the external world, and produces or processes tradable products. This little recognised fact has two important implications. First, free trade leads to specialisation in accordance with the comparative advantage of a developing economy’s modern sector, which is quite different from the comparative advantage of the economy as a whole. The reason is that the wage in the modern sector does not reflect the opportunity cost of a worker in the economy, which in fact is zero. Second, trade has significance for development only insofar as it affects the growth of saving, investment, output and employment in the modern sector and hence the process of labour transfer.

Trade pessimism was one of the hallmarks of development economics as it had evolved in the 1950s and the 1960s. It provided the basic justification for a strategy of import substitution as also for emphasis on capital goods industries in a programme of late industrialisation.2 The context for trade pessimism was the prevailing international division of labour. Over a long period, developing countries had specialised in the production of primary commodities for export while they imported modern manufactures from developed countries. This pattern of specialisation was considered unhelpful for industrialisation, which was seen as the core of any development strategy. Besides, there was no good reason for persisting with specialisation in primary commodities, which in most cases had been imposed on the developing countries by their erstwhile colonial masters and often was not in accordance with their true comparative advantage. There also were good grounds for expecting the international terms of trade to turn against primary commodities over time: income elasticity of demand was low and declining for primary commodities but high and rising for manufactures.3

These are weighty arguments, but they do not provide an adequate basis for trade pessimism. No developing country can readily dispense with imports and if primary commodities are all that it has available for export at a given point of time, it gains nothing by not exporting them. Moreover, the possibility of terms of trade being or turning unfavourable for developing countries has little to do with their specialisation in primary commodities and much to do with the very low level of output per worker in the traditional sector, which typically is the sole producer of food. For it is the relative food output per worker in one economy vis-à-vis that in another that determines the relative price of labour and hence the terms of trade between them.4 It is because food output per worker is so much lower in developing than in developed countries that the terms of trade in all non-food products tend to be unfavourable to developing countries. Moreover, any decline in food output per worker in the traditional sector of a developing country worsens its terms of trade vis-à-vis developed countries.5 And so does any growth of labour productivity in export production in the modern sector of a developing country, as the benefit is passed on to price rather than to wage (which does not change so long as food output per worker in the traditional sector remains unchanged). Thus if there is deterioration of developing countries’ terms of trade, it would be so irrespective of whether they are exporting primary commodities or labour-intensive manufactures. The problem of unfavourable or deteriorating terms of trade can be remedied only by increasing the output per worker in the traditional sector and not by changing the export products.6

Thus trade pessimism can be justified only if it can be argued that it is quite impossible for developing countries to produce manufactures for export so that trade is incompatible with industrialisation. But this is not a valid argument. Consider the following situations. If one worker in a developing country produces 1 food in the traditional sector or 1 coffee in the modern sector, while one worker in a developed country produces 5 food or 1 steel, the terms of trade between the countries will be five coffee for one steel.7 Suppose, now, that the developing country decides to produce steel in its modern sector but finds that one worker can produce only 1/7 steel. Then the domestic terms of trade will be seven coffee for one steel and it is clearly better for the country to import steel. Further, suppose that one worker in the modern sector of this developing country can produce 1 textile. Then the international terms of trade will be five textile for one steel, and textile can partially or fully replace coffee as an export item without the developing country suffering loss of any kind.

Simultaneous Import and Export Substitution

These simple examples illustrate a general point: industrialisation associated with growth in the modern sector can and should be based on simultaneous import and export substitution. For any developing country, there must be some industrial products in which import substitution is beneficial and some others that can replace primary commodities as exports. For promoting accumulation and growth in the modern sector, progressive substitution of primary commodities exports by manufactured exports is as useful as progressive substitution of imported manufactures by domestic manufactures. Indeed, replacement of primary commodities exports by manufactured exports has the added advantage, in many situations, of freeing land for food production.

It is easy to see then why trade orientation is helpful for development. A developing country pursuing a strategy of import

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substitution must produce both steel and textiles while it produces only textiles if open to trade. Since the domestic terms of trade between steel and textiles is less favourable than the international terms of trade, the total availability of steel and textiles is lower under import substitution than under trade orientation for any given level of investment. Moreover, if production of textiles is inherently less capital-intensive than that of steel, then, for any given wage rate, production of textiles alone will result in a higher output growth in the modern sector than production of both steel and textiles. This means that the rate of growth of employment in the modern sector will in general be higher under a trade-oriented strategy of industrialisation than under an import substitution strategy of industrialisation. Thus, for any given wage rate, there will be speedier transfer of labour from the traditional to the modern sector (i e, faster development) under a trade-oriented strategy. 8

It does not follow, of course, that free trade is helpful for development. Indeed, free trade can be expected to undermine development through the following channels.9 First, free trade makes export substitution extremely difficult. Under a free trade regime, the existing production/processing infrastructure in the modern sector and the established network of trade favour continued production of the traditional export products and discourage production of new products. Thus production of textile fails to develop even though its export would be at least as fruitful from the country’s point of view as the export of coffee. Second, free trade, as already noted, does not lead to specialisation according to a developing country’s true comparative advantage; it leads to specialisation according to the modern sector’s comparative advantage. It is the modern sector that engages in trade with the external world and the prevailing factor prices in the modern sector do not reflect the state of factor endowments of the economy. Paradoxical though it may seem, a developing country needs protection in order to promote specialisation in accordance with its true comparative advantage. Finally, free trade pre-empts growth of entrepreneurship in a developing country. This is the essence of the well-known “infant industry argument”. Entrepreneurs in the modern sector of developing countries need time to mature through “learning by doing” before they can compete with more experienced and resourceful entrepreneurs from developed countries. Free trade denies this learning time and hence undermines capital accumulation and growth in the modern sector.

Thus a focus on import substitution alone thwarts development while a focus on strategic substitution of both imports and exports helps development. This also means that it is strategic trade managed through a system of protection, and not free trade, which is helpful for development.

Foreign Capital and Development

In considering the role that foreign capital might play in development, we start by recalling that, at any given point of time, developing countries can be expected to fall into two distinct categories. In one category, the countries have saving rates that fall below the minimum required to launch a process of development; we can call these saving-deficient countries.10 In the other

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category, the countries have a saving rate that is adequate to sustain a process of development (though they may or may not be achieving this depending upon the kind of growth strategy they have chosen to pursue); we can call these saving- sufficient countries.

A saving-deficient developing country will necessarily experience “de-development” unless resources from abroad are available to make up for the shortfall in saving. Such a country cannot, however, expect to launch development with the help of foreign private capital. There are two main reasons for this. First, foreign private capital pre-empts the growth of a domestic entrepreneurial class, which, in a saving-deficient country, is only at an embryonic stage.11 Second, the profits earned by foreign entrepreneurs do not constitute a source of domestic saving for the developing country concerned. Thus, foreign private capital can generate temporary growth in the modern sector of a saving-deficient country (foreign private capital never flows into the traditional sector of a developing economy) but cannot be expected to generate a sustained process of accumulation.

What a saving-deficient developing country needs, therefore, is foreign aid that can supplement its domestic saving and thus enable it to achieve at least the minimum level of investment required to launch a process of development.12 Mere availability of such aid cannot of course guarantee a sustained process of development. If development is to be achieved and sustained, the government has to ensure a proper allocation of investment between the traditional and the modern sectors. It also has to be the entrepreneur that invests in the traditional sector. And it has to put in place policies required to regulate the growth of labour-incomes in both sectors should the need for such regulation arise.13

It turns out, therefore, that foreign aid can help in launching development in a saving-deficient developing country only insofar as it possesses a government that is willing and able to function as an entrepreneur. Unfortunately, it cannot be supposed that all saving-deficient developing countries possess such a government. We thus have a conundrum: while they need it, not all saving-deficient countries are effective users of foreign aid. For some of the saving-deficient countries, therefore, development may have to await the emergence of a developmental state.14

Is foreign capital of any help to saving-sufficient countries? In the development literature, foreign capital has traditionally been viewed as important not just because it can supplement domestic saving but also because inflow of foreign capital means increased availability of foreign exchange, which enables these countries to finance import of capital goods that they often need but cannot produce themselves. It has been argued, therefore, that even saving-sufficient countries often face a foreign exchange constraint, which prevents full utilisation of their domestic savings for investment and thus makes them effectively saving-deficient.15 It would seem then that foreign capital has an important role to play even in saving-sufficient countries.

However, the idea that a part of the saving can remain unutilised if certain types of capital goods are not available in required quantities is inconsistent with our assumption that all saving is out of profit. Under our assumption, if expansion of investment is impossible, expansion of saving will simply not


occur (the entrepreneurs will consume rather than save); saving equals investment both ex ante and ex post.

Thus a foreign exchange constraint, in the sense of inadequate import capacity preventing transformation of available saving into investment, cannot really exist. This does not mean, however, that increased availability of foreign exchange cannot be of any help to a saving-sufficient developing country. Insofar as the limited capacity of the traditional sector to supply food to the modern sector constrains saving/investment and/or growth of labour incomes, increased capacity to import food can conceivably enable a savingsufficient country to achieve faster development. Moreover, insofar as non-availability of specific capital goods restricts the choice of technique in the modern sector, it quite possibly restricts the rate of output growth in that sector.16 Increased availability of foreign exchange would then make it possible to increase the rate of growth of the modern sector either by increasing investment or by facilitating change of production techniques.

In many instances, therefore, increased availability of foreign exchange simply means the availability of additional resources for investment. Thus it might make sense for at least some savingsufficient countries to seek to increase the availability of foreign exchange. But if they do so, would they have reasons to prefer foreign aid to foreign private capital? There is in fact a very good reason why foreign aid should be preferred. A saving-sufficient developing country, provided that it is endowed with an entrepreneurial government, can plan the use of a certain quantity of foreign aid before seeking it, but it can do precious little to control or even influence the quantity of foreign private capital that might become available in any given period. Hence absorption of foreign aid poses far fewer problems than absorption of foreign private capital. The inflow of foreign private capital may be too little, in which case it cannot be of much help anyway, or it may be too much, in which case there arise serious problems of macroeconomic management, which call for measures that can act as restraints on domestic investors, thereby undermining the growth of domestic entrepreneurship.17

All this, quite evidently, goes against what has become a conventional wisdom: that foreign private capital can bring much benefit to developing countries.18 It is foreign aid rather than foreign private capital that can play a positive role in development. There is, however, one situation where foreign private capital can indeed bring benefits to developing countries. This is when foreign private capital is confined to “export processing zones” or “special economic zones” that are insulated from the rest of the economy. This capital then creates a “vent for surplus labour” and generates tax revenue for the government without preempting the emergence or choking the growth of a domestic entrepreneurial class.19

Concluding Observations

Trade helps speed up the process of development because it facilitates export substitution, i e, substitution of primary commodities exports by manufactured exports. Ceteris paribus, growth of the modern sector is faster when it is associated with both export and import substitution than when it is associated with import substitution alone. And that means that the pace of labour transfer from the traditional to the modern sector is faster under trade orientation than under import substitution.

But it is managed trade, and not free trade, that helps development. The reason is that the factor prices prevailing in the modern sector, which is the traded sector, do not reflect the state of factor endowments in the economy. In particular, the wage rate prevailing in the modern sector is way above the opportunity cost of a worker, which in fact is zero. In these circumstances, free trade promotes the wrong kind of specialisation, which undermines the growth of the modern sector. Paradoxical though it may seem, trade protection is required to bring comparative advantage into play.

Foreign aid can be of help to saving-deficient developing countries in that it can enable them to initiate a process of development, but only insofar as these countries possess entrepreneurial governments that can make effective use of aid. Foreign private capital, on the other hand, is most likely to thwart development except when it is confined to special economic zones that are insulated from the domestic economy. When not confined to special economic zones, foreign private capital pre-empts the growth of domestic entrepreneurship and hence sustained growth of saving and investment (profits earned by foreign entrepreneurs do not constitute a source of domestic saving). When confined to special economic zones, foreign private capital creates a vent for surplus labour and generates revenues for the state. Entrepreneurial states, once again, are required to ensure that foreign private capital creates a vent for surplus labour rather than pre-empt the growth of domestic entrepreneurship.

Notes sector lowers the real wage in the modern sector, 9 It should not come as a surprise that the freer the benefit of which is passed onto prices under trade regimes of the post-1985 period have had

1 A detailed discussion is available in Ghose (2010).

competitive conditions. adverse consequences for growth and develop2 In a closed economy, the output of capital goods 6 Here is another good reason why development re-ment in a large number of developing countries.

imposes a limit on how much investment can be quires simultaneous growth of the modern and Cf Ghose (2003).

undertaken. Growth of investment thus requires

the traditional sectors. 10 Saving-deficiency refers to a situation where the expansion of output of capital goods. This is the 7 A simplifying assumption – that the wage per saving rate is below the minimum that makes a central point of Mahalanobis (1953, 1955) and worker in the modern sector equals the output per strategy of development feasible. See Ghose Feldman-Domar (Domar 1957) models. Trade worker in the traditional sector – is being em-(2010) for a precise definition of this minimum.

pessimism makes the argument relevant even for ployed here. Actually, the wage per worker in the This notion of saving deficiency is evidently quite an open economy.

modern sector is a multiple of the output per different from the notion of “saving constraint” 3 This is the well-known Prebisch-Singer argu

worker in the traditional sector. that has figured prominently in the literature on ment. See Prebisch (1950, 1959) and Singer

8 Pack (1988) reaches a remarkably similar conclu-development (see Chenery and Strout 1966, for (1950).

sion on the basis of empirical analysis, “...the ad-example). “Saving constraint” refers to a shortfall 4 The argument was first presented in Lewis (1954). from a certain level judged desirable by develop

vantage of export orientation is allocative – fac- It was further developed in Lewis (1969, 1978);

tors can be moved rapidly from low productivity ment planners. Bhagwati (1982); and Findlay (1982). to high productivity sectors without the latter en-11 Saving deficiency is itself a reflection of the low 5 Decline in food output per worker in the traditional countering diminishing returns” (p 354). level of development of an entrepreneurial class.

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12 The proposition is most likely to be met with scepticism. Aid pessimism is the order of the day. Most economists now believe that while aid can help in achieving micro-level objectives (poverty alleviation, eradication of malaria or small pox, increasing primary school enrolment, etc), it cannot help in achieving macro-level objectives such as acceleration of economic growth. The basis for this kind of aid pessimism is the apparent failure of a fairly large number of empirical studies to find robust evidence of a positive effect of aid on economic growth in poor economies in the post-1970 period. Yet a careful reading shows that the studies report empirical results that are not just fragile but also conflicting. Some (Easterly 2003; Easterly, Levine and Roodman 2004; Rajan and Subramanian 2008) argue that aid has no effect on growth, others (Hansen and Tarp 2001) argue that aid affects growth positively on average, still others (Dalgaard, Hansen and Tarp 2004) argue that aid works outside the tropics but not in the tropics, and still others (Burnside and Dollar 2000) argue that aid works in good policy environment (defined by them as composed of openness to trade, low inflation and low budget deficits). None of the studies examines the possibility that wrong kind of aid may have been given to wrong kind of countries for wrong kind of reasons. And all conveniently ignore the familiar stories of recent economic transformation of South Korea and Taiwan and of the post-war reconstruction of western Europe and Japan in all of which aid had played a prominent role.

13 These points are discussed in some detail in Ghose (2010).

14 Collier recognises the problem but feels it can be overcome through external interventions (see Collier 2007, ch 7). He argues that the rich donor countries can help overcome the problem arising from the non-existence of developmental state in the “bottom billion” countries (i) by giving aid in the form of technical assistance for a certain period, and (ii) by insisting on a strict “governance conditionality” whenever aid is given in the form of finance. All this assumes, however, that the donors have no interest other than the development of the aid-recipient countries and that the former also know how development can be achieved in any particular country. Validity of these assumptions is certainly not self-evident.

15 Cf Chenery and Strout (1966).

16 One way of seeing this is to make the extreme assumption that non-availability of specific capital goods means a fixed-coefficient production function in the modern sector. For a given wage rate, the capital intensity associated with the fixed coefficient production function can coincide with the capital intensity that maximises the rate of output growth only by accident.

17 The major problem arises from appreciation of the exchange rate of the recipient country, which undermines exports. Preventing appreciation, on the other hand, calls for measures such as sterilization, which results in non-investment of a part of the domestic saving. Thus, as inflow of foreign capital threatens currency appreciation, and as the recipient developing country quite sensibly attempts to prevent this, foreign capital effectively crowds out domestic capital. See Ghose, Majid and Ernst (2008) for elaboration of the argument and some evidence.

18 The conventional wisdom already stands challenged, however. There is by now a good deal of evidence to show that foreign private capital neither adds to the investment rate nor positively affects economic growth in recipient developing countries. See Prasad, Rajan and Subramanian (2007); Kose et al (2009); and Rodrik and Subramanian (2009).

19 The only situation where foreign capital confined to “special economic zones” could undermine development is where foreign entrepreneurs seek to lure relatively skilled workers away from domestic enterprises by paying higher wages.


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Collier, P (2007): The Bottom Billion: Why the Poorest Countries Are Failing and What Can Be Done About It (Oxford: Oxford University Press).

Chenery, H and A Strout (1966): “Foreign Assistance and Economic Development”, American Economic Review, 56(4): 679-33.

Dalgaard, C-J, H Hansen and F Tarp (2004): “On the Empirics of Foreign Aid and Growth”, Economic Journal, 114(496): 191-216.

Domar, E D (1957): “A Soviet Model of Growth” in Domar, E D, Essays in the Theory of Economic Growth (New York: Oxford University Press).

Easterly, W (2003): “Can Foreign Aid Buy Growth?”, Journal of Economic Perspectives, 17(3): 23-48.

Easterly, W, R Levine and D Roodman (2004): “Aid, Policies and Growth: Comment”, American Economic Review, 94(3): 774-80.

Findlay, R (1982): “On W Arthur Lewis’s Contribution to Economics” in Gersovitz et al (1982).

Gersovitz, M, C F Diaz-Alejandro, G Ranis and M R Rosenzweig, ed. (1982): The Theory and Experience of Economic Development: Essays in Honour of W Arthur Lewis (London: George Allen and Unwin).

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