Impact of Changes in International Financial Flows on Trade and Production in Developing Countries

1. Seminario sobre “Estructura productiva y dinámica de precios: efectos macro-micro y respuestas de política”Escuela de Verano de Economías Latinoamericanas6 y 7 de agosto de 2008CEPAL - Sala FurtadoSantiago, Chile The Impact of Changes in International Financial Flows on Trade and Production in Developing Countries ProfJanKregelDirector, Programa sobre Política Monetaria y Estructura FinancieraLevy EconomicsInstitute del BardCollege

2. Are we in a Financial Market Driven Washington Consensus? • Original WWC (Williamson WC) Objective: • Increase Economic Efficiency • Eliminate Inflation Distortion on Decision making • Reduce Excess Demand – Monetary and Fiscal Policy • Reduce Public Distortion of Market Prices • Privatise Public Enterprises (also reduces deficit) • Eliminate price controls and subsidies • Reduce Financial Market regulations • Reduce Internal and External Debt • Reduce External Distortion of Market Prices • Open domestic goods and capital markets • Eliminate quotas and subsidies

3. WWC Did Not: • Increase Real Incomes • Increased Inequality • Increase Value Added in Exports • Increased volume of exports • Improve Degree of Domestic Market Competition • Privatisation created Oligopoly (cf World Bank) • Increase Domestic Investment • Increased Foreign Direct Investment and M&A • Increase Domestic Research/Innovation • Shifted R&D to Parent of TNC • Increase Financial Market Efficiency/ Stability • Endemic Financial Instability • Internal and External Debt Increased

4. Good Macro Policy, Bad Micro Policy? • The good macroeconomic fundamentals – • low inflation, • primary budget surpluses and • control of the money supply, • Overlooked more traditional macro economic fundamentals • high levels of aggregate demand, • low real interest rates • competitive real exchange rates. • As a result they created an overall macroeconomic environment that impeded the required structural changes at the micro level.

5. Bad Micro Policy Five areas can be identified in which the structural adjustment policies undermined the stability of the macroeconomic fundamentals and the adjustment of the production structure. • overvaluation of the exchange rate, • the high level of real interest rates, • composition of the fiscal budget, • the composition of the external account • the failure of adjustment of the industrial production structure to reduce the dependence of increased investment and increased export capacity on imported inputs.

7. What Caused the Recent Improvement? • Global Imbalances • US Fiscal Deficit – US Recovery • Low US Policy Rates - post-9/11 Recovery, Sub Prime Crisis • Developing Country Surpluses are US Deficits • Recycling of Developing Country Surpluses to US • Reinforce Low US Interest Rates – Rising Global Liquidity • Improved Terms of Trade • Financial Speculation in Commodities • Continued Industrialisation in China & India • Environmental Issues – BioEnergy • Capital Inflows • Interest Rate Differentials --Positive Carry Currencies • Foreign Investment in Alternative Energy/Commodity Supply

8. The Varying Fashions in the Terms of Trade • Original Argument of Improving Terms of Trade • Ricardo – Diminishing Returns in PC Production • Malthus – Geometry v. Arithmetic • New Prebisch-Singer-Myrdal Argument of Declining ToT – Global Distribution of Effective Demand • Technical Progress increases productivity increases Real Wages Increases per capita Income • PC trade in Global Competitive Markets, Manufactures in Administered Price Markets • Markets Compete Away Increase in Productivity in PC • Increased Productivity Goes to Real Wages in Manufactures • Purchasing Power and Real Wages increased in Manufactures and Constant in Primary Production

9. The Return of Improving Terms of Trade? • Increased Supply of Manufactured Goods • US Expansion • Developing Country Industrialisation • Capital Mobility – FDI • Labour Competes in Global Competitive Markets lowering Costs • TP lowers prices and increases TNC Profits • Increased Demand for Primary Commodities • FDI -- Industrialisation of Developing Countries • Financial Market Real Wealth Protection -- Index Funds • Hedge Fund Speculation • Rise in Price of Energy -- BioFuels • Environment – BioFuels • Raises Supply and Commodity Prices

10. Different Impact on Effective Demand • Monopsony in Commodity Markets • Horizontal Integration by TNCs • No Increase in Real Wages in Producing Countries • Oligopoly in Retail Markets • Vertical Integration by TNC • No Increase in Real Wages in Developed County Mkts • Protection of Developed Country Producers • Gatt Excludes Agriculture • US Protection –European CAP • Tariff Escalation Limits Processed Exports • Privatisation of Developing Country Production Sources • TP goes to Developed TNCs Profits not Real Wages • Increases Prices – Reduces Global Demand

11. Did Conditions Improve in the New Millennium? • Rejection of WWC • Some Never Adopted – India, China; Some Rejected -- Argentina • Improved External Balances • Improved Commodity Prices Improve Terms of Trade • Build up of External Reserves • Trade & CA Surpluses • Absence of Financial Crisis • Return of Capital Flows • Rejection of Doha Proposals • Defence of Development Round

13. Influence of Finance on Trade • Improved Trade Balance -- Improved Commodity Prices • Due to Commodities Becoming an Asset Class • Commodity Index Funds • Financial Demand dominates Commercial Demand • Low Interest Rates to Sub Prime Crisis • International Imbalances – weak $ • Environmental Policy --Subsidies to Bio Fuels • Spreads to Commodities in General • Subsidies to Energy Consumption in Developing Countries • E.g. In China gasoline and diesel prices have been kept steady since 11/2007 and electricity prices since 6/2006 • Improved Capital Balance – Foreign Direct Investment • Natural Resources • Bio Fuel Sources

14. Impact of New Terms of Trade • Exchange Rate Overvaluation – loss of Industrial Competitiveness • Restores Comparative Advantage Primary Commodity Dependence • Differential Impact on SIDs, LLDCs, LDCs • Increased transport costs impact tourism -- cf. 9/11 • Increased transport costs impact geographic dispersion of production – special export zones • Increases Volatility of Export Prices and Earnings • Shift from Final Products (food) to Intermediate Inputs • Negative Impact on Food Security • Increases Poverty • Use of Monetary and Fiscal Policy to Fight Inflation • Reduces Global Demand

15. Does this look Like WWC? • Higher Prices • Developing Country Industrialisation • Higher Oil Prices – Cost of Production of Manufactures and Primary Commodities • Bio Fuels – Higher Prices of All Soft Agricultural Commodities • Finance – Higher Futures Prices of Commodities • Attract Higher Foreign Direct Investment Flows • Response to US Financial Crisis --Interest rate differential • Attracts arbitrage financial flows • Leads to Real & Nominal Appreciation of Exchange Rate • Response to Inflation • Tighter Monetary Policy - Higher Interest Rates – Capital Inflows - Appreciation • Tighter Fiscal Policy – Lowers Demand – Reduces Wages

16. What Has Been Happening in Commodity Markets? • Financial Demand • Environmental Demand

20. Shift From Backwardation to Contango • Hedging of Commodities Produces “Natural Backwardation” Future Price is Below Cash Price • Producers of Commodities Seeking to Hedge by Selling Futures Exceeds Demand for Future Delivery • When Financial Institutions wish to Hold Commodities to Profit from Rising Prices Demand for Futures Exceed Supply from Producers • A Speculative Market had Future Price Above Cash: A CONTANGO • Increased Financial Institution Demand Has Brought Contango to most Commodity Markets

23. Size of NYMEX Non-Commercial Positions • Speculators held 48% of the open interest in NYMEX crude oil futures and options July 15 • One trader held 327,000 long and 330,000 short NYMEX crude oil futures and options positions • Total NYMEX Open Interest is around 1,600,000 contracts

24. NYMEX Sweet Light crude

26. But, Substitution Drives Up Other Prices • More Corn Planted Means Less Wheat, Soybeans, Rice • And excess demand shifts to all substitutes • Reinforces Financial Investment which further increases excess demand • Brings shift in other crop allocations • Increased Soy Acreage in Argentina and Brazil • Shift to Grain Fed Beef and Lack of Beef • Clearing of Land in Amazon – increases Carbon emissions

28. Are Improvments In Latin America ……. • Due to Financial Commodity Speculation? • Due to Speculation in Oil? • Due to Response to Climate Change? • Due to return to Monocommodity or Primary Commodity Dependence? • Are Over valued Exchange Rates and Capital Inflows Simply a Reflection of a Commodity Bubble? • What is the Impact on Industrialisation?