reducing the role of the government and trade unions and through tax cuts, deregulation, and strict monetary and fiscal policies. The wave of social-ism in Europe led by Francois Mitterrand in France and Felipe Gonzalez in Spain sought to reduce inflation and unemployment and to secure eco-nomic growth through structural reforms and nationalization of industries, and by attracting foreign investment. Helmut Kohl in Germany managed to contain inflation and consolidate the economic and monetary coopera-tion in Europe through the European Monetary System (EMS) initiated by his predecessor, Helmut Schmit, and the French President Valery Giscard d’Estaing. His greatest political achievement was the unification of Germany in 1990 although the adverse economic consequences of the unification are still haunting Germany. Japan developed an impressive current account sur-plus and became a major investor in Europe and the United States although the situation was reversed in the 1990s when Japan entered into a major economic and political crisis.4
In the 1990s there was a remarkable shift toward the market econ-omy in advanced and developing countries alike. Governments privatized state-owned enterprises, markets were liberalized and deregulated, trade barriers were lowered, and the forces of demand and supply replaced cen-tral planning. Globalization, through the increased level of trade and cap-ital movements, was intensified. This increased international integration brought into the foreground the interdependence among countries, and national governments realized that this interdependence could no longer be ignored. Regional arrangements, the most important of which are the EU, the North American Free Trade Agreement (NAFTA), and the Asia Pacific Economic Cooperation (APEC), were intensified. Another fact that demon-strated changing perceptions regarding interdependence was the resolve shown on the completion of the negotiations in December 1993 on the Gen-eral Agreement on Tariffs and Trade (GATT)—also known as the Uruguay Round—and its replacement by the World Trade Organization (WTO) in January 1995.
Globalization and Economic Activity
There has been much discussion on globalization—the name given to the closer integration of all nations through the increased level of trade and capital flows.5 It also refers to labor movement, technology transfer across international borders, as well as cultural and political issues that are beyond the scope of this chapter. Globalization is the result of technological process mainly in the areas of information technology, telecommunications, energy, transport, and biotechnology as well as a shift in economic policies. Since World War II, there has been an increasing tendency in the removal of trade
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and investment barriers. Globalization is not a new phenomenon. The world has been through a process of globalization before, as early as the sixteenth century and, more recently, at the beginning of the twentieth century6before trade and investment barriers were erected following World War I and the Great Depression.
The rationale for a market economy is increased efficiency through com-petition and specialization of factors of production. Global markets present greater opportunities for countries to have access to more funds, know-how, cheaper imports, and larger export markets. But it is also true that the bene-fits from this increased efficiency are not equally shared. All countries did not share the remarkable income growth during the second half of the twentieth century equally. The gap between the rich and the poor countries has grown.
Gross domestic product (GDP) per capita in rich countries increased sixfold during the century while that of poor countries increased less than threefold.7 At the same time, not all developing countries followed the globalization process at the same pace. Countries that followed outward-oriented policies and export-led growth, such as those of East Asia, were able to integrate into the global economy more rapidly and experience remarkable growth.
Conversely, many countries in Latin America and Africa pursued inward-oriented and import-substitution policies with disastrous results: stagnation, high inflation, and poverty.
One significant aspect of globalization is the growth of trade. Tradi-tionally, attention has focused on trade in goods (as services, to a certain extent, are considered nontraded items) as a mechanism for the integration of international economic activity and a significant transmission mechanism of economic disturbances or shocks among national economies. As Exhibit 5.1 shows, world trade continued to grow faster than world output following a dramatic rise in living standards, albeit not equally, a substantial reduc-tion in transportareduc-tion costs, a continuous improvement in technology, and a progressive reduction in trade barriers. There now exist “world products.”
Large firms in a globalized economy have subsidiaries in many countries and compete in global markets rather than in segmented national markets. The nationality of goods and services is not easily identifiable as many goods are assembled from parts made in several countries. Small and medium enterprises are increasingly taking into account the global opportunities and constraints of their investment decisions. This increased integration of the international economy has necessitated the development of trade policies.
The WTO provides a venue for trade agreements and resolves trade disputes.
From the perspective of developing countries, the removal of trade bar-riers is seen as serving the interests of advanced countries that continue to subsidize sectors such as agriculture and textiles and thus make it difficult for developing countries to exploit their comparative advantage in these sectors.
The United States and the EU have a system of preferential trade agreements
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Exhibit 5.1
World Merchandise Exports, Production, and GDP (Index, 1995= 100) 1996 1997 1998 1999 2000 2001 2002 2003 2004 World merchandise
exports Value
Total merchandise 104 108 107 111 125 120 126 146 178 Agricultural
products
103 102 97 93 94 94 100 116 133
Mining products 114 117 93 107 159 144 144 176 234
Manufactures 104 108 111 114 126 121 128 147 177
Volume
Total merchandise 105 116 121 127 140 139 144 151 165 Agricultural
products
104 110 112 113 117 119 124 128 132
Mining products 103 111 114 114 119 118 119 124 131
Manufactures 105 117 122 129 145 143 149 157 172
World merchandise production (volume)
Total merchandise 104 109 111 115 121 119 122 127 132
Agriculture 104 107 109 112 114 116 118 121 124
Mining 103 106 107 106 110 110 110 114 118
Manufacturing 103 109 112 116 123 121 125 129 134
World real GDP 103 107 109 112 117 118 120 123 127
Source: World Trade Organization website, Statistics, www.wto.org.
with developing countries whereby developing countries are given access to US and European markets. However, as mentioned above, as world markets are opened to advanced countries, they do not fully reciprocate and still attempt to protect certain sectors such as agriculture and textiles, which are of particular importance to developing countries. Developing countries as a whole increased their share in world trade from 19 percent in 1971 to 29 percent in 1999 although there is significant variation among regions, with the NICs doing well and Africa performing poorly. The most significant rise has been the export of manufactured goods while the share of primary commodities (food and raw materials) in world exports has declined.8
International trade theory tells us that free trade allows each country to benefit by exploiting its comparative advantage. While it is true that free trade hurts certain sectors as they lose market shares from low-cost competi-tors, in the long run total benefits generally outweigh losses. However, since those who are worse off are not usually compensated, there will always be
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outcries against the removal of trade barriers unless ways can be found for all to benefit.
The protest marches in Seattle, Washington, Prague, and Genoa clearly show a hostile response to globalization. Many demonstrators saw glob-alization as threatening their own jobs from low-cost competition. Others protested against the unfairness of globalization toward developing coun-tries as advanced councoun-tries still protect their markets while, at the same time, asking developing countries to open their markets to them. The problem becomes more acute for poor developing countries where unemployment is high and capital scarce. The removal of trade barriers can exacerbate the situation, as the loss of jobs can be rapid and the required investment may be too low to allow them to exploit their comparative advantage. It can be argued that the migration of factors of production from low- to high-productivity sectors will increase incomes. It can be also argued, however, that unemployment in low-productivity sectors will reduce incomes. Unless measures are taken to help these countries increase their incomes and to enable them to exploit their comparative advantage, the backlash against globalization will continue.
Globalization particularly influences financial markets as billions of dollars of capital flow from one country to another. Exhibit 5.2 shows what is often associated with globalization: increased capital flows to developing countries during the 1990s and before the global financial crisis that started in East Asia in 1997 and then spread to Russia and Brazil. The composition of capital flows changed after the crisis. Foreign direct investment became the most significant category while portfolio investment was highly volatile.
While the EU has greatly contributed to financial integration among advanced countries through decreased exchange rate volatility and reduced interest rate spreads, financial integration among developing countries devel-oped at a much slower pace.9The 1997–1999 financial crisis in the emerging markets, which turned into a global financial crisis, demonstrated that gains from globalization are not without costs—costs arising from the volatility of capital movements. Capital market liberalization in the emerging markets during the 1980s and 1990s created optimism and led to massive capital inflows. However, investors’ sentiments became volatile as they realized that these economies could not sustain a fixed exchange rate. Such a sentiment led to massive capital outflows from these markets as global investors sought to take advantage of high returns and to diversify their portfolios. Devel-oping countries were unable to manage this volatility. Trying to prevent their exchange rates from depreciating, all foreign exchange reserves were used up and the IMF provided more than $150 billion bailout packages.
Many banks became extremely weak as recession increased the number of outperforming loans.
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Exhibit 5.2
Net Capital Flows1In Emerging Markets (Billions of $ US dollars) 1997 1998 1999 2000 2001 2002 2003 2004 Total
Private capital flows, net
1950 705 881 466 478 612 1204 816 Private direct
investment, net
1449 1550 1734 1771 1912 1435 1476 1669 Private portfolio
flows, net
633 419 666 161 −913 −996 −110 −213 Other private
capital flows, net
−132 −1264 −1518 −1466 −520 173 −162 −640
Africa
565 561 664 674 605 538 700 772 Private portfolio
flows, net
67 81 561 198 −569 −596 55 120 Other private
capital flows, net
−255 −1164 −1139 −917 60 312 −228 −94
Middle East
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Exhibit 5.2 continued
1997 1998 1999 2000 2001 2002 2003 2004 Western
577 619 658 690 702 417 318 380 Private portfolio
flows, net
294 258 15 13 −94 −171 −17 −28 Other private
capital flows, net
104 −211 −300 −306 −386 −232 −301 −385
Central and Eastern Europe Private capital flows, net
202 272 367 391 121 553 515 532 Private direct
investment, net
116 192 226 239 242 251 149 227 Private portfolio
1Net capital flows comprise net direct investment, net portfolio investment and other long- and short-term net investment flows, including official and private borrowing.
2Consists of developing Asia and the newly industrialized Asian economies.
3Commonwealth of Independent States (Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Mongolia, Russia, Tajikistan, Turkmenistan, Ukraine, Uzbekistan) Source: IMF, hhttp://www.imf.org/external/pubs/ft/weo/2004/02/data /1_3.pdfInternational Insti-tutions.
A characteristic common to all emerging markets was a weak banking and financial system. There were loose supervision and prudential standards, no clear-cut capital requirements, and inadequate provisions for bad loans.
It is therefore argued that countries with weak financial systems should
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maintain restrictions on private capital flows, allowing them more flexibility in stabilizing their currencies, until they have in place well-regulated financial institutions and good macroeconomic management.10
Increased trade and capital flows as a result of globalization necessitate the presence of international institutions in order to regulate these flows.
There are three such international institutions: the WTO responsible for international trade agreements and for resolving trade disputes; the IMF, which supports the world’s financial stability by providing financial assis-tance to developing and transition economies in times of crisis; and the World Bank whose primary scope is the promotion of economic development by providing long-term loans to poor countries.11