IB Economics/Development Economics/Evaluation of Growth and Development Strategies

5.5 Evaluation of Growth and Development Strategies

Foreign Aid

---

Problems with Foreign Aid

• Aid is a poor substitute for trade: opening up MEDC markets to LEDC exports can enhance the ability of the poor to earn a living and reduce poverty
• It is estimated that less than half the aid goes to poor countries, instead it is based on the military, political and business interests of the donors, a reward to those in power

• There has been no significant correlation between the level of aid given to an LEDC and corresponding growth of GDP

• Though humanitarian/emergency aid is considered morally/ethically necessary and an important contribution at times of short-term suffering

• The LEDC government may be forced to change development policies to suit the donor's ideas:

• Loans and grants may be contingent on changes in tax laws, wage and price systems, food subsidy programs, and whether the money is used for rural or urban development
• These ideas may be out of touch with reality and do little to contribute to development in the country

• Aid contributes in direct proportion to the increase in capital investment, but aid does not appear to have accelerated the growth rates of recipient countries
• There is a lack of complementary inputs: human technical skills, administrative capacity, infrastructure, financial institutions, and political stability
• The introduction of hard currency inflows may also lead to increases in consumption rather than just investment:

• Supply bottlenecks may discourage investment in physical capital
• Rising incomes for the poor may lead to increased consumption rather than increased saving

• Aid may displace LEDC government spending (crowding out):

• There is less pressure to provide infrastructure, and necessary reforms particularly in rural areas
• Resources are then free for consumption instead of investment and may be used to acquire military hardware

• It has been persuasively argued that tied aid is not as effective as untied aid:

• LEDCs are not able to look for the least expensive goods or services but has to purchase from the donor country (more expensive)
• Creates no employment or extra output in the LEDC, because no expenditure is taking place there (money is spent on 'foreign experts' and returns to the granting country)
• Imports may also replace domestic products, which may further harm domestic industries (e.g., agricultural aid increasing supply and lowering prices)
• May be politically motivated and in fact, no more than a subsidy to industries in the MEDC
• Tied aid has actually been made illegal in some countries (UK 2002)

• Famine is often not a result of a lack of food but of the inability to earn enough to pay for the food:

• Distributing cash instead of food can stimulate the local market:

• Local traders know best how to transport supplies
• They are often able to reach inaccessible places to provide food
• Long term food production and employment can increase through investment

• Aid weariness: some in MEDCs are beginning to think that problems in their own economies are more important than problems in LEDCs and flows of aid may be reduced (current recession?)

• Politically, very popular in light of continuing allegations of corruption and misspent aid money

• Some evidence that 'targeted' short-term aid can bring about limited growth (at least in a specific sector)

• Cut flowers in Kenya and Zambia exported to Europe
• Heifer Project in Rwanda and India
• HIV/AIDS health education programmes in Botswana and Uganda

---

The Role of International Financial Institutions

---

• International Monetary Fund aims to ensure international financial stability - they provide loans under certain conditions

• Interventionist nature and seeming violation of state sovereignty an issue with SAP

• World Bank: aims to promote development to some extent

• Critics view some World Bank projects as being imposed upon countries, and not being requested locally
• Large-scale population movements (cultural destruction?) are sometimes required for dam construction (and dams are expensive with an estimated lifespan of about 25 years)
• Construction firms are often from a country that has lobbied for the World Bank loan, so loan money flows back into an MEDC

• Private sector banks: provide loans in exchange for interest

• Non-governmental organizations (NGOs): foreign aid by NGOs

MNC/TNCs: Foreign Direct Investment

---

MNC/TNCs have grown for the following reasons:

• They need to secure their supply lines of raw materials
• The need to sell to ever larger markets where new products are fully developed and competition increases the price elasticity
• Locational advantages are important:

• They need to locate within restrictive trade barriers
• Low wages, low taxes and high education levels are important
• They like to locate near markets to reduce transport costs

Problems with Foreign Direct Investment

• There are 35,000 MNCs of which 50% were controlled by US, Japanese, German and Swiss investors
• 50% of all industrial production was produced by 100 companies
• These 100 companies control 50% of world trade
• Studies have indicated that MNC/TNCs are not good at providing jobs:

• Local firms are displaced by the MNC/TNC and the displaced firms often have much higher labour capital ratios
• LEDC govts may force the MNC/TNCs to operate in a highly capital intense sector of the economy such as natural resource extraction and processing requiring massive investments in sophisticated equipment and machinery:

• The labour that is hired is very highly skilled
• Either local labour must be given extensive training
• Or skilled workers must be imported

• Labour protection laws: introduced by the government to appease the labour sector may increase labour costs significantly leading to the substitution of K for L
• MNC/TNCs may prefer to take advantage of cheaper labour by using more appropriate technology but LEDC governments anxious for technology transfer insist on the latest technology being used, once again this lowers the labour capital ratio

• Technology/managerial/knowledge transfer is severely limited by the country's ability to absorb and utilize the new technology:

• Workers lack the technical skills
• The LEDC goveernment's system of information dissemination may be non-existent
• The MNC/TNC may be extremely reluctant to accommodate technology transfer for fear of losing trade secrets

Transfer pricing: the setting of internal prices between branches of an MNC such that goods can be exported at artificially low prices:

• The MNC/TNC raises price in the next country to the market level and takes the profit there if the taxes are very low, thereby saving on income taxes
• This reduces the ability of the host govt. to collect taxes and defrauds them of taxes on work done in their own country
• 25% of all trade is between branches of the same MNC company
• The highest value added work is done in the countries with the lowest taxes
• It is a powerful tool in labour negotiations to demonstrate that the company is losing money

• Competing LEDC govts may offer concessions on:

• Reducing taxes while providing subsidies, and tariff or quota protection
• Allowing monopoly power
• Reducing environmental regulations
• However, concessions are often useless:

• Repatriated profits are simply taxed by home governments
• Tax relief may lead to confiscation of MNC property if the host government changes in the future

Foreign enclave: the MNC/TNC can increase the inequality between the rich and the poor by developing a modern high wage sector

• This sector imports luxury goods
• Inappropriate goods are marketed in the LEDC
• It widens the rural-urban wage gap leading to increased migration
• MNC/TNC supporters may influence the government to undertake projects or adopt policies which are growth rather than development oriented

MNC/TNC Policy

• Over time, nations and institutions such as labour unions have developed laws and agreements to control or balance the excess of private companies
• The problem with MNCs is that there is no global government or global union to oppose or reduce the worst excesses
• To achieve their ends LEDC governments may:

• Impose a schedule for local value added to be increased and for greater utilization of local personnel
• Impose bans on the import of used capital equipment with an insistence that only the latest technology be used
• Insist on joint ventures with local firms, and ceilings on the repatriation of profits to encourage or force reinvestment of profits in the local economy
• Insist on market pricing rather than transfer pricing on intra firm transactions
• Many MNC/TNCs now insist on proper tax payments right from the start:

• To provide enough tax revenue for the govt. to build the infrastructure needed to service the MNC/TNC
• To prevent resentment and potential nationalization which can lead to risk and uncertainty which threaten the long term viability of a project

International Trade & Economic Development

---

• About 70% of trade is between MEDCs, with the remaining 20% from LEDCs and 10% from previously centrally planned economies:

• This situation has not changed significantly for 40 years
• It is the NICs and the oil exporters which are experiencing rapid growth, the remaining LEDCs have seen their proportion of trade falling steadily

Benefits from Trade

• Comparative advantage: the potential gains from trade resulting from economies of scale and lower consumption prices can be of great potential benefit:

• Even large LEDCs may have limited domestic markets due to low income
• Small economies can achieve economies of scale through access to larger markets
• Growth: technology transfer can occur through the importing of capital goods: this can promote the rapid spread of technology
• Learn by doing: best practices in production spread rapidly through trade
• Domestic monopoly power can be reduced through international competition
• Importance of fostering South-South trade

Problems with Trade

• Foreign enclave: with wealth and income concentrated in the hands of the rich, most imports could be luxury goods
• Countries are assumed to be on their production possibility frontier when in fact most LEDCs experience high unemployment and underemployment
• Technology transfer may be pointless if it is labour saving in countries with high unemployment rates. What is needed is appropriate technology
• Risk of permanently slower growth: specialization may lock the LDCs into low skilled, labour intense production while MDCs benefit from high tech production
• Prices may not reflect opportunity cost but simply manipulation by government and firms
• Taxes, subsidies and the lack of recognition of true social costs (pollution for example) can lead to serious price distortions
• All countries CANNOT find an industry/natural resource to specialize and enjoy comparative advantage
• Markets in MEDCs are not open for exports from LEDCs
• Barriers to trade: LEDCs may find that MEDCs have already achieved economies of scale, and protect their home industries through tariffs and quotas thus effectively blocking imports from LEDCs
• Many LEDCs have turned to other LEDCs for trade opportunities
• Displacement of local production: in many LEDCs the production of cheap plastic sandals can put shoe makers out of work, backward linkages to suppliers of leather, fabric, glues, polish and packaging materials lead to even more people being put out of work
• Gains from trade will benefit foreign owned plants and factories and the profits repatriated to home countries
• High income elasticity for manufactured goods and services means that imports rise with incomes
• Price elasticity of demand for capital goods tends to be low because there are few substitutes
• Devaluation of the currency can actually lead to a larger import bill

Problems with Primary Goods Exports

• Low income elasticity of demand for primary goods, the substitution of synthetic materials and the dramatic reduction in the weight and bulk of manufactured goods have all led to virtually no growth in demand
• World demand: tends to be inelastic: there are no substitutes for primary goods:

• World supply: intense competition amongst LDCs lowers price and total revenue
• Devaluation of the currency can actually lead to lower export revenue
• In farming: supply shocks due to weather and disease combined with inelastic demand means farm revenues are very unstable

• Attempts to form cartels have met with opposition from MEDCs:

• Cartels that do survive are weak due to cheating amongst members
• Non-member increase supply and reap the benefits of the higher prices

• Alternatives to cartels are buffer stock management:

• When demand falls: the manager provides a price floor, buying and storing the excess supply
• When demand rises: the manager sells from storage and uses the profit to pay back the costs of the buffer stocks
• The costs of storage and the interest on the loans to carry the inventory are very expensive

• Supply price elasticity problems:

• In mining: shifts in demand for minerals due to MEDC economic cycles combined with inelastic supply means mineral revenues are very unstable

• Trade protection: MEDCs have increased trade protection and subsidies to their own farmers, effectively blocking imports of food goods from LEDCs
• Worsening terms of trade: prices of primary goods has fallen relative to the price of manufactured goods and services, lowering the gains from trade for the poorest countries which do not have the means to produce anything but raw materials

• Commodity agreements: agreements between developing countries in an attempt to stabilize prices for certain commodities