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Avoiding Economic Downturns Studies indicate that sustainable long-term growth requires macroeconomic policies that absorb commodity

price shocks, asset shocks, and banking crises, and reduce the risk and frequency of financial crises. Successful countries defined, for this purpose, as those reducing their per capita gross domestic product (GDP) gap with industrialized economies more effectively responded to macroeconomic shocks than others. Table 19.1 shows that, on average, developing countries experience a year of negative per capita growth once every three years, East Asian miracle economies once every six years, and the Organisation for Economic Co -operation and Development (OECD) countries once every nine y ears. The success of East Asias economies was partly a result of the macroeconomic policies that steered them away from downturns and periods of low growth. Table 19.1 The importance of avoiding downturns in growth

Source: World Bank, 2003. Note: The table shows evidence for the 89 countries for which growth data were available for the four decades 1961 2002. Regional aggregates are medians. The Republic of Korea graduated into a high -income category in the early 1990s and is thus classified here in the high-income OECD group rather than in the East Asia and Pacific group.

But African countries are different. African exports are mostly primary commodities: oil in Nigeria, Angola, and Sudan; cotton in several West African countries; tobacco in Malawi; tea and cut flowers in Kenya; copper in Zambia; diamonds in Botswana and South Africa; and so on. World prices for most of these commodities are unpredictable and volatile, and the upward and downward fluctuations in prices are not symmetrical. This creates economic fluctuations in

export revenues, local-currency-exchange-rate appreciation, and the so-called Dutch disease that affects wages in the booming sectors. Short-term agricultural price effects are different from the oil and other nonagricultural price changes. Figure 19.1 shows a strong correlation between growth of commodity prices and real economic growth, both in the short and long term: the former to leads the latter. Import substituting industrialization, financed by the commodity booms of 1970s and 1980s, did not work in Africa. Commodity booms and busts are frequent in natural-resource-dependent economies. African countries need more human capital to capitalize on surpluses and diversify their economies. Figure 19.1 Commodity price growth and real GDP growth in Sub-Saharan Africa, three-year moving average

Source: Deaton, 1999.

The Complexity of North South Linkages As summarized in table 19.1, industrialized countries growth rates, real interest rates, and exchange rates, among other policies, have major short-term effects on developing countries. The policy impacts are detailed below. Business-cycle transmission. Transmission primarily takes place through the two channels of trade and finance. The trade channel comprises foreign demand shocks, productivity shocks, and terms-of-trade changes. The finance channel comprises private capital flows, aid flows, and global financial market conditions. Foreign demand shocks. The size of the U.S. economy mean that its business cycle affects the rest of the world, especially Canada and the Latin American and East Asian countries. Th is is

true of most advanced countries: when GDP growth rates are strong, developing countries benefit, largely through trade. Likewise, a recession in the North causes a fall in imports from the South: demand falls, driving down prices on the world markets (especially for primary commodities), and the North raises import barriers (for example, steel and pharmaceuticals in the United States). These conditions lower the export earnings of developing countries, depressing their external-debt-servicing ability (such as during the debt crises of the 1980s). Despite globalization, the economic prospects of each region still depend on its largest economy. For example, the economic performance of East Asian countries closely tracks the economic performance of Japan and, more recently, China. Similarly, the performance of the U.S. economy affects the Latin American countries, and the performance of the European and South African economies affects other African countries. Every 1 percent increase in the advanced econom ies growth rates is likely to raise growth rates in emerging markets by 0.78 percent (but only 0.4 percent for all developing countries). Productivity shocks. Much of the South depends on advanced countries for technology transfers. Developing countries with strong trade ties with advanced economies suffer during slowdowns in technology imports productivity shocks account for 5 to 20 percent of the variation in output of some developing countries (Kouparitsas, 1996). Terms-of-trade changes. Economic cycles in advanced countries normally influence variations in commodity prices, which are deeply felt in African countries (see, for example, Deaton and Miller, 1995). When trade slows down for any reason, economic growth and trade credits also decline, increasing the likelihood that the nonperforming loans in developing countries will increase. Such an increase throws the commercial banks balance sheets out of alignment, putting the banking system under stress. Protectionist policies, especially during recessions. The United States decision in 2001 to put tariffs on imported steel was met with approval or, at worst, indifference at home, but in Western Europe it generated more opposition than any of Bushs policies, including his widely criticized Middle East policy. By at least three to one, people in Great Britain, France, Germany, and Italy disapproved of the tariffs. Across the globe, people expressed broad opposition to the American and Western economic policies.1 In high-income countries, subsidies account for nearly one-third of agricultural revenue. Most of the subsidies artificially boost production and undercut the market for farmers in developing countries. For example, U.S. subsidies to cotton growers totaled $3.9 billion last
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Pew Foundation funded Gallups survey of Muslim nations showed that a relatively small minority (no more than a quarter in any nation) believed that the United States and other Western nations generally care about the poorer nations. Yet the vast majority of Americans (78 percent ) think that the United States and other Western nations are concerned about impoverished countries.

year, three times the U.S. foreign aid to Africa. This depressed world cotton prices, cutting poor farmers incomes in West Africa, Central and South Asia, and other poor regions. European Union (EU) sugar subsidies had the same effect. Advanced countries benefit at the expense of the developing countries when they enforce quotas and provide agricultural subsidies to domestic producers. Lack of trade liberalization by the industrialized countries means tying of aid (estimated to cost 30 percent). Aid to developing countries is only about $75 billion per year, compared with agricultural subsidies of $350 billion. Protection in industrialized countries costs poor farmers in the developing world $150 billion each year, while implementing the World Trade Organization (WTO) agreements has cost the developing world $130 million. Since the failure of the Cancn follow -up meeting in September 2003 the Group of 22 has pressed Northern countries to end agricultural subsidies. 2 The recent backlash in the United States against business process outsourcing (as represented, for example, by offshore customer-service call centers) is another example of protectionist pressure during an economic downturn. The general public focuses on downsides of free trade job losses, increased competition, and dislocation and ignores its benefits, including lower prices (they can now buy items that are made in China for a third of the price of similar items made in the United States). Likewise, the United States pressure on China to move the exchange rate to solve the U.S.-China bilateral trade deficit is misplaced. Pending legislation would place a 27.5 percent penalty tariff on Chinese-manufactured goods imported into the United States. Labor immigration. During recessions, advanced countries often tighten their borders. For example, the recent increase in worker remittances from the United States to the developing countries could be a result of uncertainties surrounding 9/11 and ensuing job losses in these countries resulting in a repatriation of workers as well as workers transferring assets to their home countries. In a truly integrated world economy, barriers to labor integration would be rare. Aid flows. According to Bulir and Hamann (2001) and other studies, aid flows are both volatile and uncertain (normally more so than tax revenues, except in Africa) because many advanced economies link their aid policies not only to geopolitics but also to GDP levels and domestic politics. Such volatility complicates fiscal, monetary, and exchange-rate policies of the aid-recipient countries, and uncertainty is detrimental to their economic growth. Private capital inflows. Many developing countries rely heavily on external financing to fund their domestic policies and cover their current account deficits. U.S. recessions are not necessarily bad for emerging markets because the volume of capital flows to emerging markets
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It is estimated that India by cutting its own tariffs (especially in textiles, clothing, and footwear) and pressing other countries to do the same, while also reducing restrictions on trade in agriculture and services (to fully implement the multilateral trade liberalization agenda outlined in the Doha Round and Uruguay Round), got a net welfare gain of $7 billion or 1.7 percent of the countrys projected 2005 GDP.

increases during these periods. But an analysis of the composition of these capital flows indicates that foreign direct investment (FDI, the more stable component) does contract during U.S. downturns, potentially forcing emerging markets to depend for a time on short-term flows to substitute for FDI and portfolio flows. A slowdown in the North usually coincides with higher capital flows (especially in bank lending to the emerging markets) but at a time when the demand for loans in the domestic economies of the South is already declining due to a slowdown there as well. Therefore, a slowdown in mature economies is normally associated with a reduction in export volumes, a deterioration in terms of trade, and a slowdown in aid flows to most developing countries. An economic downturn in the North coincides with weaker trade and current account balances for the South. Advanced countries can deliver on their pledges to open markets that benefit poor people in developing countries by reducing distortionary agricultural subsidies. Table 19.2 NorthSouth linkages
Transmission channel Lower exports to G-3 Decline in terms of trade for the South Lower exports from the South Lower overseas outsourcing Lower agriculture exports from the South Lower aid to the South (as aid is % of GDP) Higher bank lending to emerging markets Tightened immigration in the North Outcomes in North Lower growth Lower growth Lower growth Lower growth Lower exports Lower growth Higher growth Lower remittances

Type of policy/shock Income effects Relative price effects Import barriers (for example, on steel, textiles) Restrict outsourcing Agriculture subsidies Aid flows International K-flows Restrict labor Interest-rate cycle Easy monetary policylower interest rates in G-3 International capital flows Debt servicing Interest earnings High volatility in G-3 Interest rates Bilateral exchange rate Source: IMF, 2001; and Reinhart and Reinhart, 2001.

Growth cycle: Recessions in G-3 (United States, Japan, and the 12 EU countries)

Higher portfolio flows to emerging markets Lower cost Declining interest income Complicates debt management in emerging markets Uncertainty tends to reduce investment Reduces trade between North and South

Higher growth Higher growth Ambiguous Ambiguous Lower growth Lower growth